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Smith, Barnett and the wily Salmond

Smith, Barnett and the wily Salmond

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The IFS’s estimates of Scotland’s fiscal position have caused quite a stir. No, worse than that – they have caused heated arguments, accusations of bias, counter-accusations of tetchiness and outright denial of their relevance. Those who have not been keeping up with developments since the independence referendum might struggle to understand how a set of figures estimated on the purely fictitious assumption of complete Scottish fiscal autonomy could cause such trouble. But losing the independence vote didn’t mean the SNP was going to accept the status quo. No, ever since the referendum the SNP leadership has been intent on achieving what it calls “full fiscal autonomy” for Scotland.

Exactly what the SNP means by this is not entirely clear, as will become apparent. But what everyone else understands by “full fiscal autonomy” is that Scotland would have full tax-raising, spending and borrowing powers within Scotland, in return for which it would relinquish its Barnett Formula fiscal transfers from the rest of the United Kingdom. In effect, Scotland would become a fully self-governing enclave within the United Kingdom. Suddenly the IFS’s estimates of Scotland’s fiscal position look very relevant – and very contentious.

Why contentious? Well, because they are far from flattering. In fact “ugly” is probably a fair description. The IFS projects a fiscal deficit for an autonomous Scotland of 8.6% for the next two years, substantially higher than the UK deficit:

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These estimates include oil revenues. Since tax revenues from oil exports would be a substantial proportion of an autonomous Scotland’s government income, the autonomous fiscal budget would be very sensitive to changes in the oil price: currently, of course, oil price changes are dissipated across the rest of the UK, so Scotland does not feel their full effects. The IFS recalculated its estimates in March 2015 in the light of recent oil price falls. Unsurprisingly, the projected deficit for 2015-16 worsened.

Kevin Hague produced this chart showing the projected fall in UK North Sea Oil revenues:

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 He pointed out that the gap between the “green line” (the revenue needed for Scotland’s deficit to be the same size as the UK’s) and the OBR forecasts is approximately the same size as the £7.6bn “black hole” in Scotland’s fiscal budget that the IFS identified. So Scotland’s budget shortfall is due to the falling oil price. Interestingly, this chart suggests that North Sea Oil revenues have disappointed relative to Scotland’s budget for almost the entire history of North Sea Oil production. It does not appear prudent of the Scottish government to project Scotland’s future tax revenues on the basis of oil prices returning to, and persisting at, their 2012 peak or even higher.

*UPDATE: It has been pointed out that this chart does not adjust for inflation and therefore understates real revenues from earlier years. Kevin Hague has produced a new chart which expresses historic revenues in 2013-14 terms. This gives a much better impression of the scale of the early 1980s North Sea Oil boom, but does not materially change either the situation since then or my conclusions in the paragraph above. 

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But the chart above does not explain why disappointing North Sea Oil revenues cause such a large fiscal gap. After all, as the SNP likes to remind us, per capita tax revenue in Scotland is higher than anywhere else in the UK. There really shouldn’t be such a large deficit. So, we need expenditure figures. Kevin Hague also produced this chart, which shows by how much per capita expenditure and revenue for Scotland exceeds that for the rest of the UK:

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Two things stand out from this chart: firstly, the overwhelming dependence of Scotland’s (autonomous) fiscal finances on oil revenues, and secondly, the fact that even with oil revenues Scotland’s per capita expenditure has exceeded its income in most years since 1999. Although both tax and expenditure per capita are higher than in the rest of the UK, the excess tax revenue is entirely due to oil. Onshore tax revenues per capita are persistently lower than tax revenues in the rest of the UK.  

This is the sort of revenue-expenditure profile that raises alarm bells among investors. What sort of borrowing costs does the Scottish government think it will have? Or is it expecting the Bank of England to backstop its borrowing? I wouldn’t be too happy with that idea if I were Mark Carney.

To be sure, this comparison is unfair. Scotland’s government has never had full control of tax and spending decisions, and it may be that under full fiscal autonomy it would exercise more fiscal discipline. So far the SNP has not revealed its spending plans, though Nicola Sturgeon has said that they would not involve fiscal austerity. The idea seems to be to increase public investment in order to generate higher growth. This might work, though the IFS expresses some concern:

The Scottish Government has previously suggested policies to boost growth – such as cuts to corporation tax and expanded childcare – but the immediate effect would be to weaken its finances; and it is not clear that even in the longer term the effects on growth would be enough to pay for such tax cuts and spending increases.

Of course, this assumes that the SNP gets the “full fiscal autonomy” it is demanding – which is by no means certain. We shall have to wait and see how the political debate proceeds, and what the Scottish government’s tax and spending plans look like after its next election in 2016.

Predictably, the response to the IFS’s figures has polarised along political lines. SNP supporters ignored the figures, dismissed them or questioned their validity: Kevin McKenna blithely dismissed the IFS’s figures, only to have his analysis expertly disembowelled by Kevin Hague.  SNP opponents – notably the Scottish Labour Party - were equally unreasonable, claiming that the dire financial projections made full fiscal autonomy impossible: Nicola Sturgeon rightly pointed out, in an acrimonious political debate hosted by the BBC’s Sunday Politics programme, that a large fiscal deficit did not mean that Scotland could not run its own affairs.  

And now Alex Salmond has joined in. Writing in the National, he claims that the IFS’s figures are completely irrelevant because of the Smith Commission’s “principles” agreed in October:

Smith took out an effective insurance policy before he had the parties sit down. He dragooned them into agreeing to a set of principles before they set about agreeing to the precise proposals.

This was done on October 23 last year. Principles five and six are the ones which concern us here. Principle five set out the policy of “no detriment” while number six was even more explicit, guaranteeing any devolution proposal should be made without Scotland or Westminster “gaining or losing financially”.

That means whatever is devolved in taxation, an equal amount of revenue is deducted or added to the financial arrangements between Scotland and London. That would apply whether a lot is devolved, as the SNP proposes, or just a little is conceded, as the London parties suggest.

It would apply whether the transfer of power occurred in a year when Scotland was in a stronger or weaker budgetary position than that of the UK as a whole.

It renders ridiculous the claims of Labour of a supposed “financial black hole”. Unless, of course, they are explicitly reneging on what they solemnly signed last October.

So I looked up the Smith Commission report. The exact wording of the Smith Commission principles is this:

Those principles stated that the package of powers agreed through the Smith Commission process, when taken together, should:

(1) form a substantial and cohesive package of powers, enabling the delivery of outcomes that are meaningful to the people of Scotland.

(2) strengthen the Scottish devolution settlement and the Scottish Parliament within the UK (including the Parliament’s levels of financial accountability).

(3) aim to bring about a durable but responsive democratic constitutional settlement, which maintains Scotland’s place in the UK and enhances mutual cooperation and partnership working.

(4) not be conditional on the conclusion of other political negotiations elsewhere in the UK.

(5) not cause detriment to the UK as a whole nor to any of its constituent parts.

(6) cause neither the UK Government nor the Scottish Government to gain or lose financially simply as a consequence of devolving a specific power.

(7) be implementable; be compatible with Scotland’s and the UK’s international obligations, including EU law; and be agreed with a broad understanding of the potential associated costs.

I have highlighted principles 5 and 6 as these are the two principles cited by Salmond in support of his argument that the IFS’s figures are irrelevant.

On the face of it, Salmond’s argument appears sound. If the consequence of Scotland being granted full fiscal autonomy was that it immediately had to bear losses arising from oil price falls that it currently does not bear because the effects of oil price changes are dissipated across the whole UK, then it would unquestionably be in a worse financial position as a direct consequence of devolution of North Sea Oil tax revenues to Scotland. Conversely, the rest of the UK would no longer bear losses that it would previously have borne, so it would be in a relatively better financial position. The budget projections from the IFS reflect this: Scotland’s projected deficit worsened when it was recalculated to take recent oil price falls into account, while the effect on the rest of the UK was negligible.

The Smith Commission principles are intended to ensure that reductions in Barnett formula fiscal transfers match transfers of tax revenues. At present, tax revenues from North Sea Oil go to the UK Treasury, and Scotland receives a share of them in its block grant. Cuts in tax revenue due to oil price falls at present are absorbed into general taxation: Scotland’s block grant only reduces if overall government spending falls. Clearly, if oil tax revenue reductions are not offset by tax revenue increases elsewhere or additional borrowing, but are compensated by spending cuts, then Scotland’s grant reduces. But it does not reduce by the full amount of the tax revenue lost due to oil price falls.

On devolution of North Sea Oil tax revenues to Scotland, the block grant would be reduced by the full amount of those tax revenues, since the UK Treasury would no longer receive them. If North Sea Oil tax revenues fell, therefore, the Smith Commission principles would force an increase in the residual block grant, thus protecting Scotland from feeling the effects of the oil price fall. (Note that this is a significant complication of the Barnett formula, since for devolved functions it would flex according to revenue not spending.) In effect, the UK would insure Scotland against the consequences of oil price falls. But in the event of higher tax revenues due to an oil price rise, of course, the block grant would reduce and the tax revenue would flow back to the UK. Scotland would be protected from price falls but unable to benefit from price rises. You could regard this as a sort of swap arrangement between the UK and Scotland.

But under full fiscal autonomy, Barnett fiscal transfers would end. There would be no block grant for Scotland, since Scotland would no longer participate in UK tax-raising or spending. Scotland would pay the UK for common services such as defence and foreign policy, but there would be no fiscal transfers between the two countries. There would therefore be no automatic mechanism for the UK to absorb changes in North Sea Oil tax revenues.

If the Smith Commission principles still applied under full fiscal autonomy, the UK would have to pay Scotland compensation for falls in the oil price that are entirely beyond the control of either country. It is not clear to me in what way such an arrangement could be said to constitute “full fiscal autonomy”, since it amounts to a continuing system of fiscal transfer from the UK to Scotland. It would be extremely unpopular with the UK electorate, who would inevitably see it as Scotland both having its cake and eating it. And it is doubtful if Scotland would be able or willing to compensate the UK for loss of North Sea Oil tax revenue increases if the oil price were to rise. I suspect that this would prove an asymmetric arrangement. It is a poisoned chalice and to my mind entirely contrary to the spirit, if not the letter, of the Smith Commission principles, which are designed to ensure that sharing of risks and resources remains equitable as powers and responsibilities shift around. 

HMG makes it clear that there would be no risk and resource sharing under full fiscal autonomy:

The Smith Agreement devolves substantial new powers while allowing Scotland to continue to pool risk and share resources with the rest of the United Kingdom. It does not deliver full fiscal autonomy to Scotland. Indeed, the benefits of pooling risk and resources would be lost under full fiscal autonomy, as it would have been had Scotland opted for separation.

And HMG goes on to state explicitly that the UK would not protect Scotland from the fiscal consequences of changes in tax revenues:

However, under full fiscal autonomy, Scotland would also bear the consequences of a reduction in any revenue stream as well as any unexpected increase in public spending…..

…if Scotland were fiscally autonomous then any drop in revenues would have to be covered by Scottish finances, either through increased tax revenues, cuts in public spending or increased borrowing.

In short, there would be no fiscal transfers under full fiscal autonomy, and no compensation for tax revenue losses due to oil price changes. The IFS’s figures are therefore relevant, whatever Salmond may say. Scotland would start its life as a fully autonomous fiscal entity with a very large fiscal deficit and highly vulnerable to price changes in a volatile commodity. It is hard to see how significant debt-funded fiscal expansion in pursuit of growth can be consistent with such a situation.

The Smith Agreement was never intended to enable fiscal transfers from the UK to Scotland to continue under full fiscal autonomy. It could not possibly survive such twisting of its core purpose. Salmond’s inflammatory remark about “reneging” on the Smith Agreement thus ignores the reality of the path down which the SNP seems intent on travelling. Full fiscal autonomy means the end of the Smith Agreement. Only a few months after it was signed, the SNP leadership is already planning to trash it. And you cannot renege on an agreement that the other side intends to consign to the bin.  

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